NEW$ & VIEW$ (12 JANUARY 2016): 2008 Redux?

Most Retailers Beat December Estimates But Still Post Weak Results

The Thomson Reuters Same Store Sales Index actual result for December 2015 showed a gain of 0.6%. Excluding drug stores, the index registered a 0.8% comp. in both cases, the estimate was for 0% growth. (…)

Retailers are blaming the warmer-than-usual weather and a strong dollar (weaker tourist spending) for the slowdown in consumer spending. (…) Costco has the biggest weighting in our index, and posted a 1.0% SSS, and is being hurt by gasoline sales. Excluding gas, Costco posted a robust 5.0% SSS.

Looking forward to Q4, our Thomson Reuters Quarterly Same Store Sales Index, which consists of 83 retailers, is expected to post 1.1% growth for Q4 (vs. 2.8% in Q4 2014).

BTW: Over the past 7 trading days, gasoline futures have plunged -16 cents, putting retail prices, which declined to $1.96 yesterday, on track to decline over the next six weeks to $1.83. (ISI)

Bank of America: Rail Traffic Is Saying Something Worrying About the U.S. Economy

(…) “We believe rail data may be signaling a warning for the broader economy,” the recent note from Bank of America says. “Carloads have declined more than 5 percent in each of the past 11 weeks on a year-over-year basis. While one-off volume declines occur occasionally, they are generally followed by a recovery shortly thereafter. The current period of substantial and sustained weakness, including last week’s -10.1 percent decline, has not occurred since 2009.”

BofA analysts led by Ken Hoexter look at the past 30 years to see what this type of steep decline usually means for the U.S. economy. What they found wasn’t particularly encouraging: All such drops in rail carloads preceded, or were accompanied by, an economic slowdown (Note: They excluded 1996 due to an extremely harsh winter).

“Similar periods of weakness have occurred in only five other instances since 1985: (1) the majority of 1988, (2) the first half of 1991, (3) several weeks in early 1996, (4) late 2000 and early 2001, and (5) late 2008 and the majority of 2009 … all either overlapped with a recession, or preceded a recession by a few quarters.” 

Of course, many would argue that a shift away from coal-powered energy, a slowdown in the industrial sector, and the petering out of the U.S. shale boom would naturally lead to fewer goods being moved by rail. Hoexter and his team, however, suggest that the slowdown is spreading to more consumer-oriented segments. Intermodal carloads typically related to consumer goods were up 1 percent in the first quarter of 2015 and 3.6 percent in the second quarter but fell 1.7 percent in the final quarter of last year. (…)

More on this in yesterday’s New$ & View$.

ENERGY

• Oil prices near $30 as selling continues Opec schisms suggest supply cuts agreement unlikely

• Oil Plunge Sparks Bankruptcy Fears Crude-oil prices plunged more than 5% to trade near $30 a barrel, making the specter of bankruptcy ever more likely for a significant chunk of the U.S. oil industry.

As many as a third of American oil-and-gas producers could tip toward bankruptcy and restructuring by mid-2017, according to Wolfe Research. Survival, for some, would be possible if oil rebounded to at least $50, according to analysts. (…)

More than 30 small companies that collectively owe in excess of $13 billion have already filed for bankruptcy protection so far during this downturn, according to law firm Haynes & Boone.

Morgan Stanley issued a report this week describing an environment “worse than 1986” for energy prices and producers, referring to the last big oil bust that lasted for years. The current downturn is now deeper and longer than each of the five oil price crashes since 1970, said Martijn Rats, an analyst at the bank.

Together, North American oil-and-gas producers are losing nearly $2 billion every week at current prices, according to a forthcoming report from AlixPartners, a consulting firm, that is set to be published later this week. (…)

American producers are expected to cut their budgets by 51% to $89.6 billion from 2014, a reduction that exceeds the worst years of the 1980s, according to Cowen & Co. There is no relief in sight: The oil glut is expected to continue well into 2017, according to several banks, analysts and industry executives. (…)

If an array of U.S. shale companies go bankrupt or assets fall into new hands and bondholders get crushed, bankruptcies will wipe the debt slate clean and lower the oil price needed to fetch a profit.

Projections for losses on energy loans continue to rise broadly, and some banks have started to raise their own forecasts for such losses. In a biannual review by a trio of banking regulators, the value of loans rated as “substandard, doubtful or loss” among oil and gas borrowers almost quintupled to $34.2 billion, or 15% of the total energy loans evaluated. That compares with $6.9 billion, or 3.6%, in 2014.

The largest U.S. banks have relatively small energy portfolios in the context of their overall lending. For instance, in the third quarter Wells Fargo & Co.’s oil-and-gas loan exposure was 2% of its total loans, roughly $17 billion, according to company filings. The bank, one of the largest energy lenders in the U.S., reports earnings Friday.

Since financial distress hasn’t been a good mechanism for slowing down U.S. oil production, many analysts fear that any pullback may come too late. U.S. government estimates pegged output at 9.2 million barrels a day at the start of 2016—1% higher than the start of last year when oil was trading for 40% more.

• BP plans new deep staff cuts to withstand oil price storm

• Petrobras cuts five-year investment plan by 25 per cent

• More liquidity: American LNG goes global

The Energy Atlantic has arrived at Cheniere Energy’s Sabine Pass terminal in Louisiana to ship the first-ever exports of liquefied natural gas from the “lower 48” states. Though regulatory obstacles have eroded, the business climate is now daunting: prices have slumped in Asia and Europe just as large new LNG export facilities are opening in Australia and elsewhere. Liquefying and transporting gas are costly, but—ignoring the capital cost of the terminals—rock-bottom American prices mean companies may still make $2 profit for each million British Thermal Units (28 cubic metres) shipped, reckons Timera Energy, a consultancy. The exports will also change global gas pricing, because American LNG contracts are linked to the Henry Hub benchmark in Louisiana, not the world oil market. Even slim pickings for shippers won’t stop more convergence in global LNG prices as American exports go to the highest bidder. (The Economist)

Canada: How cheap is the CAD?

In a speech last week, Bank of Canada Governor Poloz argued that the current decline in commodity prices is one of the most complex shocks that a policy-maker can face. Under these circumstances, the most important facilitator of adjustment is a flexible exchange rate. As today’s Hot Chart shows, the Canadian dollar has come a long way. At this time last year, when the Bank of Canada surprised markets with a rate cut, the CAD was overvalued against both its PPP or the “Big Mac” index produced by The Economist. One year later, the loonie is the most undervalued in a decade against both measures. Against this backdrop, we believe that the Governor was justified to mention that “other complementary” policies can be deployed to offer a broader array of buffers while still encouraging the necessary longer-term adjustments to the Canadian economy, including fiscal policy. (NBF)

Just so you know, the correlation between the CAD and WTI is 0.94 since 2013…

What is the probability of the RMB seeing sharp depreciation (to 7 and beyond) against USD?

From CEBM Research:

Not very probable. First, the suggestion that the RMB must undergo significant devaluation carries a hidden assumption, that is, knowledge of where the RMB ‘equilibrium’ exchange rate should be. But FX rates are different from interest rates. No one knows where an equilibrium exchange should be. Hence, relying on market forces alone, and allowing speculators to profit through short selling, it’s very possible that the RMB would overshoot its fundamental value. The PBoC’s new press release indicates the post-reform RMB exchange rate will abide by market forces. By this they mean obeying the demand and supply for foreign currency by real economy, not by the needs of leveraged, pro-cyclical speculators.

Second, a massive devaluation will bring little stimulus to China’s exports in the short-term. Before November 2015, China accounted for 13% of global exports. In 1993, Japan’s share of global exports peaked at 9.8%. We do not know if there is a ceiling on a country’s share of global exports, but we do know that as a country’s share of global exports increases its ability to stimulate incremental exports via exchange rate devaluation weakens. In China’s case, given its high share of global exports, devaluation will not be extremely effective in generating incremental external demand driven growth. Also, as emerging market currencies increasingly follow the RMB, China’s ability to stimulate marginal export demand growth via devaluation also weakens. Furthermore, competitive devaluation causes capital to flee emerging markets, resulting in zero or negative effect on China and other emerging economies.

It’s worth noting, right after the August 11th reforms, overseas investors initially believed that the Chinese government was trying to devaluate to lift exports, leading to further pessimism towards the health of Chinese economy. This is one of the reasons that commodities prices began to fall along with a number of other asset prices. In retrospect, there have been disagreements over the magnitude and timing of the August 11th devaluation. But at the time, the PBoC’s primary goal was to make the exchange rate more flexible, which would give domestic monetary policy more space to maneuver. Stimulating exports was not the primary consideration.
Third, even if massive devaluation can be tried as a matter of economics, the political feasibility is nil. A massive devaluation would trigger harsh criticism and pressure from the U.S., especially given the upcoming presidential election. Furthermore, a massive devaluation would hinder the Federal Reserves ability to guide monetary policy expectations. As we saw last September, the Fed did not raise rates in part due to RMB instability. Thus, RMB volatility, if it continues, may jeopardize the expected March rate hike. In addition, since the August 11th reforms, domestic firms have made the natural choice to reduce foreign currency denominated leverage. But a sharp depreciation makes retiring outstanding foreign currency debt even harder.

However, should any of the scenarios listed below happen in 2016, the possibility that the RMB will depreciate above USD/CNY= 7 will increase:

1) The Federal Reserve makes repeated rate hikes and the dollar strengthens significantly.
2) The Chinese economy has a hard landing and recedes along all sectors.
3) Major policy mistakes.

Worst Case Scenario:

A lack of sufficient intervention to support the USD/CNY exchange rate could lead to entrenched expectations for depreciation, a rapid rundown on FX reserves, falling RMB denominated asset prices and panic that would likely spread to global markets. The likelihood of this scenario playing out in 2016 in our opinion remains low for several reasons: (1) China will maintain a current account surplus in 2016 helping to maintain its FX reserve war chest;(2) The relative yield advantage on RMB assets will help to keep net outflow levels at a manageable level; (3) China’s economy remains relatively strong compared to other countries and still has plenty of room for reforms to unlock potential growth; (4) administrative measures in the form of capital & current account controls or a move back to a stronger peg with the USD can be implemented if necessary.

Official Says China Has Tools to Defeat Bets Against Yuan Wagers that the yuan will slump 10% or more against the dollar are “ridiculous and impossible,” a senior Chinese economic official said Monday, warning that China had a sufficient tool kit to defeat attacks on its currency.

It’s About The Dollar, Not The Renminbi

Good piece by Charles Gave via John Mauldin:

In my 50 year career working in financial markets, I have never seen the money supply of one country move across the border to another country. Hence I must confess to being perplexed when reading recent commentary fretting about “capital flight” from China.(…)

Capital flight episodes have, in fact, almost always occurred at times when a country’s money supply has an unsustainable counterpart in foreign debt. When circumstances conspire so that servicing this debt becomes difficult, the outcome is usually a plunging money supply, soaring short rates and a collapse in economic activity; Thailand in 1997-98 was a classic case. The standard precursor to such an emerging market crisis is for an economy to run a current account deficit, and so rely on capital inflows. I have never seen such a financial crisis unfold when the country in question was running a large current account surplus. (…)

As I see it, the main risk in the current turmoil is not that the renminbi declines due to Farmer Wong shifting his savings abroad, but rather as a result of the dollar soaring against all other currencies; in particular against the currencies where domestic players have received lots of dollar loans from Chinese banks (commodity producers in particular). This, of course, is what happened in 1981-1985 and to an extent in 2008-09 as a result of a massive short-covering exercise that caused the dollar deposit base outside of the US to shrink brutally.

So my advice remains not to watch the renminbi, but instead to keep focused on the US dollar. A debt deflation always occurs when the currency in which the debt is denominated starts to rise for reasons that nobody understands. We may be at that very point.

CHINA VEHICLE SALES JUMP

December sales were 2.79 million units, up 15.6% YoY. ISI calculates that sales rose 5.9% MoM seasonally adjusted. For all of 2015, sales were up 4.6% after +6.8% in 2014.

I am a big fan of Christopher Wood, the strategist at CLSA. Chris is a smart, poised, out-of-the-box thinker. Long-time reader Gary is kind enough to occasionally send me Chris’ pieces. Some excerpts (my emphasis).

• Liquidity???

(…) Concerns about liquidity in the debt markets usually relates to redemptions engulfing open ended mutual funds. And it is certainly the case that US high-yield funds have seen significant net redemptions over the past two years. Thus, US high-yield bond mutual funds recorded US$33bn of net outflows in the year to 16 December 2015, following a US$44bn outflow in 2014. But a further aggravating factor, which has not received the attention it should have done, is the growth in debt exchange traded products (ETFs) in recent years. Net assets in US bond ETFs have risen sixfold, from US$57bn at the end of 2008 to US$342bn at the end of November 2015.

It should be noted that ETFs began life as an equity product. GREED & fear does not believe in ETFs because they involve an insidious commoditisation of investment. But equity ETFs are more defensible because stocks are listed on an exchange. It is hard to see how ETFs can replicate debt markets in a liquidity panic, most particularly when such bonds are not even listed on an exchange. GREED & fear is sure there are lots of complicated explanations arguing the opposite. But GREED & fear does not believe them – just as GREED & fear did not believe self-interested apologists for complicated securitisations back in 2006. In this respect, debt ETFs have created a dangerous illusion of liquidity that does not exist in such over-the-counter markets. (…)

Alhambra calculated gross issuance of junk bonds, leveraged loans and collateralised loan obligations (CLOs) in America in the three-year period between 2012 and 2014 as totalling US$2.8tn. This was contrasted with US$1.3tn of total subprime mortgage loans outstanding in March 2007 at the onset of the housing crisis. Including gross issuance in 2015, the tally rose to US$3.6tn.

There is, then, more than enough dodgy dollar-funded debt out there, both onshore and offshore, to trigger renewed credit concerns, with refinancing risk the obvious catalyst. This is likely to take the deflationary form of rising credit spreads in the context of a flattening yield curve. This is why the base case here remains that, when presented with the financial equivalent of “withdrawal symptoms” in the form of rising credit spreads and related collateral damage in stock markets, the Fed will reverse its stance on monetary policy and resume easing – which is, by the way, the same reversal of policy carried out by every other central bank in the developed world which has tried to tighten monetary policy since 2008. Examples include Sweden, Norway, Australia and the ECB. (…)

• This is where the oil dividend went.

As regards the condition of the American economy, the biggest surprise to the consensus prevailing at the start of 2015 was the continuing failure of consumption to pick up more robustly despite the steep decline in energy prices, as reflected in continuing lacklustre retail sales data. (…)

Still, the anaemic consumption trend should not surprise given the continuing lack of wage growth for the average American; the psychological trauma triggered by the 2008 financial crisis; and the collapse in interest income on savings as a result of seven years of zero rates. It is also worth GREED & fear mentioning again the squeeze on discretionary spending posed by rising healthcare costs and rising rents in America. US personal spending on healthcare and insurance increased by US$151bn over the 12 months to November, accounting for 43% of the US$355bn increase in total personal consumption expenditure over the same period. (…)

As for rents, Zillow Research reported that rents rose by 3.8%YoY in November, while a recent study by the Joint Center for Housing Studies of Harvard University (America’s rental housing – Expanding options for diverse and growth demand, 9 December 2015) showed that the number of “cost-burdened” renter households (defined as households paying more than 30% of income for housing) rose from 14.8m in 2001 to a record 21.3m in 2014. While the share of cost-burdened renters rose from 49% of all renters in 2013 to 49.3% in 2014, near its all-time high of 50.8% reached in 2011. (…)

SENTIMENT WATCH

• RBS cries ‘sell everything’ as deflationary crisis nears

• Average S&P 500 Stock in Bear Market Territory

The chart to the right is an update to one we included in a B.I.G. Tips report last Thursday which showed the average percentage decline stocks have seen from their 52-week highs based on market cap and sectors.  Through Friday’s close, stocks in the S&P 500 (large cap stocks in the S&P 1500) were down an average of 22.5% from their respective 52-week highs.  Mid-cap stocks, which make up the S&P 400 index were down an average of 26.5% from their 52-week highs, and small-cap stocks (S&P 600) were the worst of the bunch with an average decline of more than 30% from their 52-week highs.  With everyone focused on the S&P 500’s 10% decline from its intraday high last May, the majority of stocks in America are already in their own bear market.

The chart below breaks down the average percentage decline of stocks in the S&P 1500 by sector.  This chart clearly outs the Energy sector as the primary driver of weakness in US equities. Through Friday’s close, the average decline for stocks in that sector has declined more than 50% from its 52-week high. That’s more than cut in half!  After Energy, the next weakest sector is Materials, but with the average stock in that sector ‘only’ losing a third of its value, it doesn’t seem that bad relative to Energy.  In terms of sectors where stocks have held up the best, at 14.3% and 18.5%, respectively, Utilities and Consumer Staples are the only two sectors where the average stock is not in bear market territory.

Is this really 2008 all over again?

GEORGE Soros’s record is sufficiently impressive, particularly on macro-economic calls, that it is worth taking notice when he sounds the alarm. His latest suggestion is that the current environment reminds him of 2008, the prelude to one of the worst bear markets in history. The reputation of George Osborne, Britain’s finance minister, is nothing like as elevated but he is also set to warn today that the current year may be the toughest for the global economy since the financial crisis. 

Stockmarkets certainly seem to be acting as if Mr Soros might be right. (…)

So is it 2008? Mainstream forecasters aren’t predicting recession (but they never do). The World Bank has cut its forecast for global growth in 2016 from 3.3% to 2.9% (although that would be better than 2015’s outturn). Perhaps one should look at the trend in forecasts, rather than the outright level; back in January 2008, Federal Reserve governors were looking for 1.3-2% growth that year. That was way too optimistic, but the direction of travel was right; the previous range of forecasts (in October 2007) had been 1.7% to 2.5%. Falling commodity prices and (in the first few days of the trading year) falling bond yields are an indication that investors are worried about growth.

There are certainly signs of weakness in the manufacturing sector. The US manufacturing ISM indicator is at 48.2, below the crucial 50 level; the long-term picture shows that it has been weaker than this level, without indicating recession, but a fall below 45 would be a pretty reliable signal of a downturn. China’s manufacturing PMI is at the same level. Global trade is also sluggish; something that economists struggle to understand.

On the other hand, the services sector (by far the largest part of developed economies) is pretty robust; its December ISM was 55.3 in the US. The ADP figures showed a strong rise in US employment in December (the non-farm payrolls are out tomorrow). And not all the news in manufacturing is bad. German new orders were up 1.5% in November, the second consecutive strong monthly rise, prompting Andreas Rees of Unicredit to argue that 

the widespread pessimism, especially on stock markets, is largely exaggerated. Instead of further steep plunges in foreign demand for German exporters, it looks as if there is a turnaround.

A judicious view might be that global growth is still sluggish, but it will probably need some trigger to plunge it into outright recession. Geopolitics is one possibility; Iran has just accused Saudi Arabia of bombing its embassy in Yemen and if the Sunni-Shia proxy war turned into a real war, that would surely have a powerful impact.

But the 2008 parallel can only be sustained if we are talking about a debt bubble bursting, and Mr Soros specifically focused on China. 

To the extent there was euphoria and rampant speculation (as there was in 2006-07), we are really talking about China rather than Europe or the US.

As the chart shows, there has been a sharp rise in China’s debt-to-GDP ratio, with a 50 percentage point increase in the last four years. Just as with the sub-prime loan boom in the US, a rapid increase in debt suggests that loans are being made without sufficient attention being made to credit quality and that resources are being misallocated. The general consensus, however, is that China can handle a debt crisis; state control of the economy is much greater and the government has trillions of dollars of reserves with which to rescue the banks if it needs to. Nor are Chinese banks as tied into the western financial system as Lehman Brothers and Bear Stearns were; the contagion will be limited.

Of course, this state control means that non-performing loans are not recognised as quickly as they are in the west and that, as a result, struggling companies do not go out of business. These zombies hang around and make it much more difficult for competitors (including western companies) to be profitable. So the contagion effect will not be via the financial system but via corporate profits. 

John-Paul Smith of Ecstrat, a noted bear on China, argues that

Whilst the majority of industrial enterprises have reacted to the slowdown in demand in a rational manner by reducing capex as proportion of sales, the aggregate impact of their actions is exacerbating the pronounced deflationary tendencies in the broader economy, so that capacity utilisation at the majority of enterprises is still falling, while debt levels continue to move higher.

The fear is that the Chinese authorities, desperate to avoid the social unrest that would result from unemployment if businesses fail, will choose instead to devalue their currency. The yuan has weakened at a measured pace already in 2016 and investors have reacted with concern, but the shock would come from a much bigger fall. China’s real effective exchange rate (see the chart from the St Louis Fed) is now 130, compared with an index level of 100 in 2010. 

Capital flight from China is already occurring and the stock market falls are likely to encourage more outflows. As Mr Smith points out

aggressive intervention to shore up the currency by selling dollars from the FX reserves, will tighten domestic liquidity and therefore risk exacerbating the very conditions, which have brought about capital flight in the first place, thereby triggering a vicious circle.

If China devalues, then other Asian nations will come under pressure to follow suit, for fear of losing competitive position. That will trigger worries about those Asian companies that have borrowed in dollars. There could be banking issues in Asia (read more about emerging market debt problems here).

This is a potentially worrying scenario. Whether 2008 is the right parallel is another matter. If the bearish case does come true, then it sounds more like 1998 when a round of Asian devaluations was triggered by the realisation that growth had been fuelled by speculation. Western economies did manage to overcome that crisis. The real worry is that emerging countries are a lot more important for the global economy than they were back then.

• The questionable logic behind the Fed’s premature rate rise The Federal Reserve is way too concerned about the possibility of a sharp and sustained increase in inflation

Plunges in commodity prices bleed into the core. When the core PCE deflator slowed in 1985-1987, the Fed eased. When the core PCE deflator slowed in 1996-1998, the Fed eased.

• 4 Reasons This Is Probably Not A Good Time To Freak Out (ISI’s Ed Hyman)

We have just had the worst start to the year in two decades.  A client/friend sent us an email yesterday, “Why aren’t you freaking out?”  Here are 4 reasons why:

1. The US expansion is slow but solid, and the next recession is still years out.

2. US wages are accelerating, but the CPI is not, ie, price inflation is still MIA.

3. Fed policy is still “extremely expansionary”, ECB and BoJ are still expanding their balance sheets, and PBoC is in an easing cycle. The US yield curve is still positive.

4. We believe that China growth is stabilizing and that the SHCOMP is likely to end the year up.

Citigroup’s Buiter Sees One-in-Three Chance of U.K. Exiting EU

Apple: Live long and suffer 

(…) That cuts both ways, though. A recent survey by Accenture found that the proportion of consumers who expected to buy a smartphone in the next 12 months had fallen to 48 per cent from 54 per cent last year; the drop was particularly severe in China. Another survey by Mizuho found that 81 per cent of iPhone users expected to hang on to their next device for longer, an estimated 27 months compared with 20 months. The iPhone 5 has demonstrated more staying power than previous versions of the device; it has not yet been rendered obsolete by more processing power or killer features from subsequent iterations. In Apple’s sales pitch to worrywart shareholders, that is the wrong sort of iPhone endurance. (FT Lex)